2 Main Topics Demand Supply Market equilibrium Elasticities of demand and supply2-2
3 Demand Curves Product’s demand curve shows: How much buyers of the product want to buy at each possible priceHolding fixed all other factors that affect demandOn a graph: vertical axis shows $ per unit of the good, horizontal axis shows quantity demanded per unit of timeDownward sloping (buying the product is less attractive when the price is high than when the price is low)2-3
4 Determinants of Demand Demand curve holds all factors other than the product’s price constant:Population growth; # of consumersConsumer tastes and incomesPrices of other productsSubstitutes (An increase in the price of one product causes buyers to demand more of the other, all else equal)Complements (An increase in the price of product causes buyers to demand less of the other, all else equal)Government taxes or regulations2-4
5 Shifts and Movements Along a Demand Curve Change in price of the product causes a movement along the demand curveA change in the quantity demandedChange in another factor causes the entire demand curve to shiftA change in demand2-5
6 Figure 2.1: Demand Curve for U.S. Corn Market (hypothetical) 2-6
7 Demand FunctionsProduct’s demand function is a mathematical representation of its demandDescribes the amount of the product buyers demand for each possible combination of price and other factorsCan be determined by applying statistical techniques to historical data2-7
8 Sample Demand Function Demand for corn affected by: price of corn, price of potatoes, price of butter, consumer incomesIncreases in the prices of corn and butter will decrease the amount of corn buyers demandIncreases in the price of potatoes will increase the amount of corn buyers demand2-8
9 Sample Problem 1 Plot the following demand curve for wine: Qd = 20 – 4PW + 5PB + 0.2IWhere PB (the price of beer) is $2, and I (income) is $20How does the demand curve change if average income rises to $50 or the price of beer falls to $1?
10 Supply Curves Product’s supply curve shows: How much sellers of the product want to sell at each possible priceHolding fixed all other factors that affect supplyOn a graph: vertical axis shows $ per unit of the good, horizontal axis shows quantity supplied per unit of timeUpward sloping (selling the product is less attractive when the price is low than when the price is high)2-10
11 Determinants of Supply Supply curve holds all factors other than the product’s price constant:TechnologyPrices of inputsPrices of other possible outputsGovernment taxes or regulations2-11
12 Shifts and Movements Along a Supply Curve Change in price of the product causes a movement along the supply curveA change in the quantity suppliedChange in another factor causes the entire supply curve to shiftA change in supply2-12
13 Figure 2.2: Supply Curve for U.S. Corn Market (hypothetical) 2-13
14 Supply FunctionsProduct’s supply function is a mathematical representation of its supplyDescribes the amount of the product sellers supply at each possible combination of price and other factorsCan be determined by applying statistical techniques to historical data2-14
15 Sample Supply Function Supply of corn affected by: price of corn, price of diesel fuel, price of soybeansIncreases in the price of diesel fuel and soybeans will decrease the amount of corn sellers supplyIncreases in the price of corn will increase the amount of corn sellers supply2-15
16 Sample Problem 2 Plot the following supply curve for wine: Qs = 2PW - PB - 0.3PFWhere PB (the price of beer) is $2 and PF (the price of fertilizer) is $10.
17 Market EquilibriumSupply and demand for a product interact to determine the market equilibriumThe equilibrium price is the price at which the amounts supplied and demanded are equalGraphically, the price at which the supply and demand curves intersect2-17
18 Figure 2.3: Equilibrium in the Corn Market 2-18
19 Excess Supply, Excess Demand If price is above equilibrium price:Amount supplied will be greater than amount demanded (excess supply)Incentive for sellers to lower prices to boost salesIf price is below equilibrium price:Amount demanded will be greater than amount supplied (excess demand)Incentive for buyers to offer higher pricesMarket prices adjust so that amount supplied equals amount demanded2-19
20 Sample Problem 3Find the market equilibrium given the following supply and demand functions:Qd = 20 – 4PW + 5PB + 0.2IWhere PB (the price of beer) is $2, and I (income) is $20Qs = 2PW - PB - 0.3PFWhere PB (the price of beer) is $2 and PF (the price of fertilizer) is $10.
21 Changes in Market Equilibrium Changing market conditions alter the market equilibriumChanges in the determinants of supply (or demand) other than the product price cause the supply (or demand) curve to shiftExample: falling diesel fuel and soybean prices shift the corn supply curve out2-21
23 Changes in Market Equilibrium Four possible ways either supply or demand curve can shift:Demand can increase or decreaseSupply can increase or decreaseEffect on market equilibrium:If demand curve shifts, price and quantity change in the same direction as the curveIf supply curve shifts, quantity changes in the same direction as the curve but price changes in the opposite direction2-23
25 Changes in Market Equilibrium Sometimes supply and demand will both shiftUltimate effect on equilibrium is combination of the separate effects of changes in demand and supplyWill be able to determine the necessary direction of price or quantity movement, but not both2-25
26 Figure 2.9: Increase in Both Demand and Supply 2-26
27 Size of Changes in Market Equilibrium What determines the size of changes in market equilibrium?Size of change in demand (or supply)The larger the shift in demand (or supply), the larger the effect on price)Steepness of the curve that does not shiftIf the supply curve shifts, the steeper demand curve the more the price changes the less the amount bought and sold changesSteepness reflects responsiveness to prices2-27
28 Figure 2.11: Changes in Equilibrium for Two Extreme Demand Curves 2-28
29 Figure 2.13: Changes in Equilibrium for Two Extreme Supply Curves 2-29
30 Elasticities of Demand and Supply A measure of the responsiveness of the amounts demanded and supplied to changes in pricesNot the same as the slope of the supply or demand curve, which depends on unit of measurement.Elasticity does not depend on units (e.g., gallons, dozens, dollars per pound)Can compare elasticity across goods and services.2-30
31 General Elasticity Formula Suppose that a change in X causes a change in Y.Then the elasticity of Y with respect to X is the percentage change in Y divided by the percentage change in X:2-31
32 Interpreting an Elasticity SupposeThen Y increases 2% for each 1% increase in XIf instead Y decreased 2% when X increased by 1%, the elasticity would be negative.Note that the elasticity is unit-free; its meaning is clear without information about the units of X or Y.2-32
33 Price Elasticity of Demand Elasticity of demand for a product with respect to its priceUsually called “elasticity of demand”DenotedElasticity of demand equals the percentage change in the amount demanded divided by the percentage change in the price2-33
34 Price Elasticity of Demand Formula:Expect Ed to be negative:When P increases, amount demanded typically decreasesWhen P decreases, amount demanded typically increases2-34
35 Price Elasticity of Demand Goods tend to have more price elastic demand when:They have close substitutesBuyers of the product consider it a luxuryBuyers of the product are strapped for cash and thus sensitive to changes in their expendituresIn general, elasticity of demand varies at different points along a demand curve2-35
36 Elasticities for Linear Demand Curves For linear demand curves re-write the price elasticity of demand formula as:Notice that the first term is related to the slope of the demand curveThe second term is the initial price divided by the initial quantity2-36
37 Categories of Elasticity of Demand Condition for EdElasticEd<-1Inelastic0>Ed>-1Perfectly ElasticEd=infinityPerfectly InelasticEd=0Unit ElasticEd=12-37
38 Total Expenditure and Elasticity of Demand Total expenditure equals P*Q, the product of the price and the total amount demandedElasticity of demand shows how total expenditure changes when price increasesTE will increase with a small increase in price when demand is inelastic and decrease when demand is elasticTE is largest at a price for which elasticity equals -12-38
39 Figure 2.18: Price, Elasticity, and Total Expenditure TE increases where demand is inelastic; for prices below $3.75TE falls where demand is elasticTE is largest where Ed = -1; when price = $3.752-39
40 Income Elasticity If EI>0, the good is a normal good. Consumption rises as income increases.If EI<0, the good is an inferior good.Consumption falls as income increases.
41 Cross Price Elasticity If Exy >0, the two goods are substitutes.If Exy <0, the two goods are complements.
42 Price Elasticity of Supply Responsiveness of a product’s supply to changes in its priceElasticity of supply equals the percentage change in the amount supplied divided by the percentage change in the priceBasic ideas are the same as for elasticity of demand2-42
43 Sample Problem 4You are the marketing manager for XYZ Corp. You have this regression result for your product: Q = 2000 – 3.5*P + 1.2*I.Right now, your price is 10, and the average income of your customers is $30,000.compute income elasticityis your good a normal good or an inferior good?You expect a recession. You estimate that your customer's average income will fall 5% due to this recession. Estimate the impact on your sales.